The pressure on junk bonds: With thin spreads, experts worry defaults will pile up

Suzanne CosgroveTribune staff reporter

Low U.S. interest rates have been a boon for the junk bond market in the last few years, allowing companies to take on new debt at a rapid clip.

What that has meant for investors, and the outlook for junk bonds going forward, is less certain. While many investors have been fixated by the stock market's gyrations, others are taking a hard look at the bond market, including junk bonds.

Last year, corporate debt issuance advanced at the fastest pace in five years, "as new issuance turned increasingly aggressive, moving away from refinancing," according to a recent report by Fitch Ratings Inc.

Against the backdrop of a stable economy and a Federal Reserve that has stayed the course on interest rates since June, defaults on debt--failure to make timely payments of principal and interest--have been at historically low levels, analysts say.

In a recent research report, Fitch said the U.S. high-yield default rate ended 2006 at 0.8 percent, down from 3.1 percent in 2005 and well below a long-term average rate of 5 percent.

And Standard & Poor's study of global corporate debt in 2006 showed the total number of defaults was the lowest since 1997.

But that may not continue, experts said, which should give investors pause.

Scott Berry, associate director of fund analysis for Morningstar Inc., advised investors to "keep reasonable expectations for the [high-yield] asset class. It's not offering a lot of yield for the risk, and double-digit returns are going to be difficult to get."

"With just the prospect of slower profit growth and rising debt" in 2007, it increases potential risk for holders of junk bonds, said Mariarosa Verde, Fitch's managing director of credit market research. Add an abrupt stock market sell-off like the one seen Feb. 27, and it "accelerates investors' awareness of that risk," she said.

"Individual investors should try to stick with the higher-quality names that will have less volatility in any downturn or sell-off," said Kim Noland, director of high-yield research for Gimme Credit, an independent corporate bond research firm.

"An uncertain economic outlook," coupled with "the prospect that earnings can't continue to grow at [their] current pace, is certainly a concern in the market," Noland said.

A bond characterized as junk, or high yield, generally carries a greater risk of default than higher-rated investment-grade bonds. In exchange for that risk, investors theoretically earn higher returns than on most other bonds.

Junk bonds, for example, yielded 7.11 percent last week, according to KDP Investment Advisors' daily high-yield index, compared with the 10-year Treasury bond's 4.5 percent. While junk bond yields are higher, the spread between them and Treasuries in recent months has been small by historical standards.

For those who still see opportunities in junk bonds, experts suggest investing via high-yield mutual funds. Many big mutual fund houses have funds that invest in high-yield debt.

The average high-yield fund has yielded 2.3 percent for the year through Feb. 28, and the average one-year return is 10.4 percent, according to Morningstar.

"What is important to note here," Fitch's Verde said, "is that despite strong economic growth since 2004, companies have not been motivated to permanently reduce debt" on their balance sheets.

"We expect that the global default rate will edge up from its trough" this year, said Diane Vazza, head of Standard & Poor's Global Fixed Income Research Group.

In addition, "a rising share of low-grade originations" and "a pick-up in negative bias" as measured by outlooks and CreditWatches are factors that suggest caution down the road, S&P warned.

New corporate bonds issued in 2006 totaled $804.3 billion, according to Fitch. Of that total, $677.6 billion were investment-grade bonds, and $126.7 billion were speculative grade, or junk. That compares with $662.2 billion in new corporate bonds issued a year earlier--$543.1 billion investment grade and $119.1 speculative grade.

Many companies kept high debt levels while they took on leveraged buyouts and share buybacks, higher dividend payouts, and mergers and acquisitions, Verde said.

As a result, "we've had a consistent move down the ratings scale," Verde said. Even cash-strapped companies with some of the lowest credit ratings "had access to capital at good terms, with low rates. All of this has been done with the backdrop of good [economic and corporate] growth," she said.

Typically, the lowest-rated companies need access to capital just to service their existing debt, Verde said. "They live on a wing and a prayer."

Experts said certain sectors are likely to be less vulnerable than others.

"We think the gaming/lodging sector and energy companies are probably on sound footing in the near term. Autos and home builders could continue to disappoint," Noland said.

In 2006, 40 percent of outstanding U.S. auto-related industrial bonds suffered downgrades, much of it related to credit erosion at General Motors Corp. and Ford Motor Co., Fitch reported.

Going forward, the sectors that have outlooks skewed to the negative "are all the usual suspects," such as autos, housing and retail, Verde said. "The wild card is consumer spending if the economy slows down."

Ward McCarthy, a managing director at Stone & McCarthy Research Associates in Princeton, N.J., predicted that the markets would see "a return to rationality" after the late February swing that lifted prices of Treasury securities while stocks nose-dived.

Looking at the economy, "we're looking at below-trend, below-capacity growth," McCarthy said. "Our view is that going into the summer months, slower growth would prompt the Fed to ease.

"The bond market has been and continues to be in a transitional phase. It's between a [Fed] tightening stage and an easing phase."

In those periods, he said, "you tend to get volatile moves in yields and yield curves."

Funding conditions were "optimal" in 2006, Verde said. "Borrowers were able to get excellent terms," and loan covenants "were fairly weak," she said.

"Low B and CCC issuers may have been able to refinance at attractive rates, but if there is a hiccup in their operating performance or an economic downturn, they could run into trouble," Noland said.

"We think bond investors should be prepared for continued volatility as the market digests the various economic reports, and as bond players try to determine where yields might be headed next," Morningstar's Berry said.

"And while corporate bonds have often provided some protection against rising rates, that may not be the case this time around. With corporate bond yields creeping closer to Treasury yields in recent years, the sector has grown increasingly rate sensitive."